Kevin Welsh, a senior vice president with the New York institutional group at CB Richard Ellis, would agree. "I like to use the expression 'debt is the new equity, " he says, adding that the notes are "typically being acquired by relatively sophisticated investors." Some buyers acquire the notes with the goal of eventually gaining control of the property (see "Loan to Own? Expect the Unexpected," beginning on page 14) while others are less concerned with real estate than with maximizing yield.

The current holders of the note have plenty of motivation for selling them, experts say. Many lenders, whether banks or life companies, have had distressed assets on their books

for a long time and are becoming increasingly frustrated with the amount of time it takes to foreclose on properties. Moreover, due partly to the Federal Reserve's accommodative monetary policy, lenders have been enjoying substantial profits over the past several quarters, and so they are in a position to withstand selling at a loss while cleaning up their balance sheets.

To Michael Fay, Southeast regional head of the asset resolutions team at Colliers International, selling notes represents "a way for these groups to get the problems off their books. What they're effectively doing is shoving the problem onto another group, and that other group is going to have to foreclose as well. So it's not that foreclosures or REO sales are going to go away, they're just moving paper from one group to another group for specific reasons, such as reserve issues and cleaning up balance sheets."

Adds Fay, "It's also a great tool for dealing with a problematic borrower. The lender says, 'You can sit here and work this out with us, or we're going to sell your note to someone else who ultimately either wants to own the property or will sell the note off again:

It's a little bit of a carrot-and-stick method."

Selling notes is also a way to help bridge the yawning gap between supply and demand. In late June, for example, Invest corp Real Estate sold Talos Capital Ltd. a $100-million mortgage loan on a Washington, DC office property that the US Coast Guard uses for headquarters space, for an undisclosed sum. "We saw an opportunity to sell this mortgage at a strong profit given investors' renewed interest in commercial real estate loans and the dearth of quality assets changing hands these days," commented Jon Dracos, co-head of Investcorps real estate business.

The proliferation of note sales is very much a function of the most recent cycle, say commercial real estate veterans who remember the days of the Resolution Trust Corp. "This is so different from the '90s, it's incredible," says Welsh. "If you looked at the capital structures that were in existence then, it was mostly senior lenders. Everything was so much clearer in terms of who owned the real estate and where the risk lay. You weren't dealing with the complex capital structures." Therefore, REO sales came thicker and faster than is the case in 2010.

Given the time-consuming slog that the foreclosure process often represents today, lenders see note sales as a quicker route. But there is a tradeoff. "Absolutely you're not going to get as much through a note sale as if you take the property through foreclosure and sell it yourself," says Greenland.

Proceeding from that assumption, the question becomes why the bank would willingly lower its return through a note sale. "Undeniably it is because there's a race right now to prove that you have a healthy balance sheet," Greenland says. "To do that is to show stabilized or reduced non-performing assets or REO. That lS-to-24-month

lag it takes to foreclose hurts you in a market where net consolidation is starting. So it's all about getting your balance sheet healthy, and the quickest way to do it is to sell the assets. But that presumes that you have the capital adequacy to do it."

Many banks are now in a better position to do this than they were a year ago, Greenland says. "One, they've had time to increase their reserves," he notes, "and two, there's more price transparency now, so there's less concern about where the terminal asset values are going in the next year or two."

That means prices on the buy side have firmed up a little, so the bid/ask spread is narrower. A report from Jones Lang LaSalle's retail investment sales group points out that notes typically sell for between $0.55 and $0.75 on the dollar of outstanding balance. "Though the lender or special servicer takes a loss, the loan holder is able to avoid what are often lengthy and costly foreclosure processes that can be fraught with legal risk," according to the JLL report, which cites a Credit Suisse credit update that advocates resolving specially serviced loans "the earlier the better" via discounted payoffs or note sales to shorten timing in serving and exhibit lower loss severity "The longer an asset sits in special servicing, the higher the loss rate that special servicer takes," says Kris Cooper, managing director of JLLs retail investment sales group. "Distress holders need to move quickly to execute an exit strategy to clear their balance sheets of assets and notes to mitigate losses efficiently."

For buyers, the discounted purchase price on notes compared to REO helps offset one of the pitfalls, namely, that the investor may not actually get to the real estate. On a grand scale, Welsh points out, that's one of the risks faced by the joint venture of Pershing Square Capital and Winthrop Realty Trust in its recent discounted purchase of the $300-million senior mezzanine debt on the 1l,227-unit Peter Cooper Village/Stuyvesant Town apartment complex in New York City. No sooner than the JV bought the debt than it faced an injunction by the senior lenders, who were planning a foreclosure of their own on the $3-billion first mortgage.

Welsh says he's confident that the JV is "eventually going to get to a point where they sell co-ops, condos or whatever" at Stuy- Town. "But rest assured, that's a tough row to hoe," he says. "You've got to feel pretty good about maneuvering through the various headwinds that will definitely exist through the process."

Other buyers, Greenland points out, "may be restricted by their investment criteria to buy only distressed debt, not distressed assets. If I'm a fund that's raised money to buy distressed debt, I'm limited in the universe" of buying opportunities. "Conversely, I may get a better opportunity by going in and not trying to get to the asset but restructuring the debt, yet having a fallback in case I get the asset."

Note sales may take two forms. Banks or special servicers may sell portfolios that pool loans from across a wide geographic area. Each of the loans will come under scrutiny by the investors, looking at what stage of the foreclosure process it has reached, how the note's value can be enhanced and how to optimize the loan's value for resale.

That was the approach behind last month's joint-venture acquisition of a portfolio of 38 non-performing loans by Ram and Square Mile Capital Management. Backed by 39 shopping centers across nine Southern states, the portfolio carried a total par value of $150 million, the purchase price was not disclosed, although a release notes that the loans were acquired at "a significant discount" to par.

"The recent transaction with Square Mile was the first large portfolio that we seriously considered purchasing," says Casey Cumming, president of Palm Beach Gardens, FL-based Ram. "In the past 18 months, distressed debt investing has represented an overwhelming majority of our new transactions. The acquisition of commercial mortgages on a selected basis will continue to be a positive addition to our traditional acquisition and redevelopment programs."

Similarly, Milwaukee-based M&I Bank recently tapped Mission Capital Advisors to market $273.9 million worth of loans in various stages of distress. The 55-loan portfolio is being divided into six regional pools, with final bids due Sept. 15. "Our credit quality trends continued to benefit from our aggressive approach to nonperforming loan identification and resolution," Greg Smith, M&I's CFO, said on a recent earnings call.

Funds and other large-scale investors may find advantages in buying a portfolio "because they're limiting the amount of competition," says Greenland. "When you limit competition, you reduce price. For some people, there are certain types of transactions where price does not matter or is not as significant a driving force, where a portfolio transaction could make sense. But from a proceeds standpoint, it's never advantageous."

Alternately, a distressed debt holder may sell a single note, collateralized by a property or a portfolio of properties. This type of buyer is pursuing the loan-to-own strategy, and it's the kind of customer DebtX is looking for. "We believe in selling at the asset level to increase proceeds," says Greenland.

Whether it's one-off or portfolio sales, the potential buying pool for notes is arguably unprecedented. Fay says he's never seen so much capital in the market as there is now, and particularly as compared to the RTC era.

Just as lenders may differ on whether to sell portfolios or whole notes, so investors have a variety of reasons for buying in one or the other format. Fay says that although investors may share several characteristics, including the dollar ranges of the investments they're prepared to make, it's difficult to generalize about their note strategies.

"There are so many different investment groups with different plays," he says. "I will tell you that there is a buyer for everything out there."

Would-be buyers need to look very carefully before diving into the notesale waters. "You always want a good idea of exactly where the lender stands in the foreclosure process, what the status of the litigation is and what the defenses are that had been raised by the borrower," says one expert. "You want to know the exact structure of the capital stack so that you understand fully who is involved and to what extent they're involved. And you really need to be very good on what the documents are. If there is more than one lender, you want to make sure you understand what the intercreditor agreement says."

Industry observers predict that, while note sales will rise as more distress comes to market, it won't be a permanent increase. Fay says there are REO portfolios coming to market where the whole foreclosure process has already been gone through. "That is going to have a trickling effect over the next five years," he says. "We're going to have a lot more note sales over the next two to three years, and then they will start to pull back and REO will really speed up."

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